CDS (II) 2023 General Knowledge · Question 66 of 120

Correct — B, Money multiplier will decrease. The money multiplier is the ratio of the total money supply to high-powered money, and in its standard form it depends on two leakages — the fraction of money the public chooses to hold as currency rather than deposits, and the fraction of deposits banks must keep as reserves. Writing the currency-to-deposit ratio as c and the reserve ratio as r, the multiplier moves inversely with the sum of the two. When people shift out of deposits and into cash in hand, c rises. Currency held in a pocket does no further work: it cannot be lent on, so it creates no derived deposits. Every rupee that leaves the banking system for a purse is a rupee removed from the base on which credit creation builds. The denominator therefore grows, the multiplier shrinks, and for a given stock of high-powered money the total money supply is smaller. This is exactly why a rise in the banking habit of a population raises the multiplier — it is the same relationship read in the opposite direction.

• (a)Money demand will increase — Confuses the composition of money holdings with their total. People are choosing to hold the same wealth in a different form — more cash, fewer deposits — which is a portfolio shift, not by itself an increase in the demand for money.
• (c)Money multiplier will increase — The exact reverse of what happens. The multiplier rises when the currency-to-deposit ratio falls, that is when people bank more of their money, because a larger share of each rupee stays available for banks to lend on.
• (d)Money demand will decrease — There is nothing in the described behaviour to suggest people want to hold less money in total. They are simply relocating it from bank accounts to cash.

High-powered money, or reserve money, is what the central bank creates — currency with the public plus bankers' deposits with the central bank. The broader money supply is a multiple of it, because a deposit placed in a bank can be lent out, spent, redeposited and lent again. Two things stop that chain from running forever: the reserves banks are required or choose to hold, and the cash the public keeps outside the banking system. The money multiplier is what remains after both leakages are accounted for.

Questions on the multiplier are best answered by tracing a single rupee. Deposit a rupee, the bank keeps a fraction as reserve and lends the rest, and the loan returns as a fresh deposit somewhere; each round adds to the money supply. Now hand that rupee to someone who keeps it under a mattress: the chain stops at step one. From that picture the direction of every variant of the question follows — anything that keeps more money inside the banking system raises the multiplier, anything that pulls money out of it, or forces banks to hold more idle reserves, lowers it. Note also that the multiplier falling does not mean money supply must fall; it means each unit of central bank money now supports less broad money.

• The money multiplier is the ratio of broad money to high-powered money, and it depends on the currency-to-deposit ratio and the reserve ratio.
• A higher currency-to-deposit ratio lowers the multiplier; a stronger banking habit raises it.
• Raising the Cash Reserve Ratio or the Statutory Liquidity Ratio also lowers the multiplier, by raising the reserve leakage.
• The Cash Reserve Ratio is the share of net demand and time liabilities that banks must hold as balances with the Reserve Bank of India.
• M3, which adds time deposits with banks to narrow money, is the aggregate most commonly used in India.

• Reading a shift from deposits to cash as an increase in the demand for money rather than a change in its composition.
• Getting the direction backwards. More cash outside banks means a smaller multiplier, not a larger one.
• Assuming the multiplier and the money supply always move together; the multiplier can fall while the central bank expands the base.

Most often as a one-line direction question — what raises or lowers the multiplier — and occasionally as a numerical using the reserve and currency ratios.

• practice — not a real PYQ

  The money multiplier in an economy will increase if

  • (a)the Cash Reserve Ratio is raised
  • (b)the public shifts from bank deposits to holding cash
  • (c)the banking habit of the population strengthens
  • (d)banks choose to hold larger excess reserves

  Answer(c) the banking habit of the population strengthens — a lower currency-to-deposit ratio leaves more of each rupee available for banks to lend on.

• practice — not a real PYQ

  High-powered money in an economy consists of

  • (a)currency with the public plus bankers' deposits with the central bank
  • (b)demand deposits with commercial banks only
  • (c)time deposits with commercial banks only
  • (d)the total loans outstanding of the banking system

  Answer(a) currency with the public plus bankers' deposits with the central bank — the base on which the multiplier operates.